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Cryptocurrency 101

Allworth Co-CEO Scott Hanson breaks down the basics of cryptocurrency and explains why, in our eyes, it's still a risky investment.

 

How knowledgeable are you about cryptocurrencies?

While I encounter some folks who are very well-versed about them, there’s still a lot of confusion about what cryptocurrencies are and how they work - mostly because they’ve only been around for a little over a decade and there’s a lot of misinformation floating about.

So, what are they?

Cryptocurrencies are both an investment alternative and a decentralized currency, which basically means they aren’t backed by real assets or tangible securities, making them a bank-less way to make payments. But using cryptocurrencies, also known as “peer-to-peer money,” “virtual currency,” “cyber-cash,” and “digital currency,” you not only bypass the third-party bank, but you also skip over the fourth party of government oversight, regulation, and FDIC insurance.

Confused yet?

When it comes to brands, Bitcoin is pretty much the “Coca-Cola” of cryptocurrencies. In fact, a lot of people believe that Bitcoin is the only cryptocurrency, and so, as with “Coke,” or even a tissue product such as “Kleenex,” although there are perhaps 5,000 other types of cryptocurrency, Bitcoin has become the generic trademark of the digital currency world.1  

This is unsettling for a lot of people.

That’s because, for the last few hundred years, with some exceptions, currencies have largely been of the “bank money” variety, which means they were either “fiat” or “representative.” Fiat money is physical currency that is established and backed by a government. Representative money, say, like a check, is typically backed by an asset such as the money in your bank account, or some other financial instrument.   

What are the basic mechanics of cryptocurrencies?

While some people use cryptocurrencies to purchase things, as with almost anything that can be owned, priced, and coveted, some people view them purely as viable alternative investments.

From a technical standpoint, cryptocurrencies are an asset that is both digital and encrypted. The “digital” aspect means that the currency is “stored” as "bits" in the virtual world and does not exist in physical form. (A “bit” is a basic unit of information in computing and is short for “binary digit.”)

The “encryption” part of the equation means that advanced coding is involved in the storing and transmission of the currency data for safety and security.

I agree that, at this point in time, and purely as a topic of conversation, cryptocurrencies are fascinating.

One reason is that cryptocurrency transactions are “cryptographic,” which is a way to protect the communication and information of the transaction via the use of coding.

Another is that each transaction is presumably verified by “blockchain technology.”

 

What is blockchain technology?

While it may seem complex, the reason for a blockchain is straightforward: it acts as a ledger that keeps a record of the cryptocurrency transactions. Simply, it’s a database, and each time a new transaction occurs, it creates its own block which is, once filled with data, combined with the other blocks in the string to form a chronological chain.

Typically, the data in the blockchain is decentralized (no single individual has control), it’s permanent, and it’s viewable to everyone in the chain. In this way, those people who use the cryptocurrency have their own copy of the blockchain’s transaction records, with each user’s figurative ledger updated in real time.

Which all sounds fine until...            

                                                                                                                     

So, how do blockchains protect against fraud?

There are a couple of different validation tracts in place that help to protect the cryptocurrency ecosystem.

Among these, first, there’s “proof of work,” wherein an algorithm is generated off a mathematical problem that the computers solve. The computers of people in the blockchain are “miners,” which helps verify the transaction. (The computer that solves the puzzle is rewarded with additional cryptocurrency for the effort.) Bitcoin uses this type of validation.

There's also “proof of stake.” These are mechanisms that select “validators” in direct proportion to the user’s holdings in that specific cryptocurrency. (Proof of stake systems are preferable to many people because they use significantly less power than what is required to solve the mathematical puzzles required for authentication in proof of work validations.)     

The second step for authentication of a transaction is a “consensus mechanism,” whereby each transaction must be approved by a majority of users in the blockchain.

 

Is cryptocurrency a good investment?

Anyone who is interested in investing in cryptocurrencies needs to understand the risks.

While there are some incredibly intelligent people working to make the cryptocurrency market safe for investors, and while the government has been laying the groundwork for potential future cryptocurrency regulation, the fact remains that besides being highly volatile, it’s not regulated or federally insured, and so it lacks oversight.

While there are systems and safeguards in place to help protect the public, and while other financial industries certainly have experienced instances of fraud, just earlier this month (August 2021), the largest known cryptocurrency theft ($675 million) in history occurred when a blockchain site was hacked. (Though reportedly half was later returned.)

The difference between that fraud and the fraud of deposits in most financial institutions is that any money that doesn’t get returned by the hackers of that cryptocurrency is probably gone forever.

This recent known theft of $675 million comes after more than $475 million had been stolen in the first seven months of this year (2021), and after some $1.9 billion was reportedly taken in 2020. 1

Part of the problem with security and blockchains and cryptocurrencies stems from the fact that all the systems generally operate independently of one another, which makes a unified defense more difficult. And while there are some players in the cryptocurrency exchange insurance business, because this alternative investment is both highly volatile and new, most private insurance companies remain on the sidelines.

None of this changes the fact that people are curious about cryptocurrencies. If that applies to you, and I can’t emphasize this enough, please speak with your fiduciary financial advisor before investing in the cryptocurrency market.       

1 https://www.bbc.com/news/business58163917#:~:text=Hackers%20have%20stolen%20some%20%24600,digital%20tokens%20such%20as%20Ether.